On Nov. 3, 2009, Warren Buffett bagged his elephant.
Last year's $44 billion buyout of Burlington Northern transformed Berkshire Hathaway
A delightful dilemma
Berkshire Hathaway, you see, generates anywhere from $8 billion to $10 billion a year in cash -- cash that, as Buffett laments, just "piles up." Here at The Motley Fool, we think that generating too much cash is an enviable situation, but for Buffett, it's always posed a problem.
You see, unlike many of the companies he invests in -- Coca-Cola
With the dividend outlet firmly corked, Buffett has for years wrestled with the problem of how to put his vast profits to work effectively. That's a problem a lot of us wouldn't mind having, I suspect. But first, we have to make those profits.
Free cash flow: What is it?
At its simplest, "free cash flow" is the cash profit that a company has left over after paying its expenses. It is money the company can use to pay dividends to shareholders, build new factories, and hire new workers, or simply sock away for a rainy day (or decade). What free cash flow is most definitely not, though, is the "profits" that most Wall Street analysts focus on when deciding whether a company is a "buy," "sell," or "accumulate strongly with an option to hold."
An example may help to illustrate the concept. Consider a hypothetical company: Peoria Occidental Orthodontic Robotics (Ticker: POOR), a manufacturer of electric toothbrushes. Incorporated with $100 million in start-up capital in 2010, POOR embarks upon its business by pouring $100 million into building a toothbrush factory in Peoria, Ill. By 2019, POOR is selling $10 million worth of toothbrushes annually, toothbrushes that cost it $5 million to manufacture and sell.
POOR generates $5 million in annual cash flow. Because its factory has already been built, is highly automated, well-oiled, and so requires almost no maintenance, its capital expenditures are negligible. Thus, every year that POOR makes $10 million in sales, it deposits $5 million in the bank. So POOR's profitable, right?
Not according to Wall Street. You see, bright and shiny as it looks from the outside, POOR's accountants "depreciate" $10 million of the value of its factory every year for 10 years, to account for the initial expense of building it. As a result, at the same time as POOR is putting $5 million in the bank, it's telling the IRS, Wall Street, and pretty much everyone else who focuses on GAAP accounting, that it lost money for the year. And yet the company's bank account has been growing fatter and fatter with each passing year.
Free cash flow: Who's got it?
Now POOR is, of course, a fictional company (and really, any investment banker who let a company go public with a ticker symbol like this one would find himself flipping burgers at Mickey D's in short order). But there are a whole lot of companies that offer the same rich investment opportunity in the real world as POOR does in the imaginary.
Some of them look unprofitable, but are actually cash-rich; others look to be doing OK under GAAP, but are actually churning out gobs of cash far in excess of what many people expect:
Actual Free Cash Flow
Valero Energy Corporation
||$128 million||$147 million|
||$608 million||$1.2 billion|
||$2.5 billion||$3.1 billion|
||$6.6 billion||$8.6 billion|
Data from Finviz.com and Capital IQ refer to trailing 12 month results.
Buy when Wall Street won't
Here at the Fool, we'd love to own a stock like POOR -- indeed, within our Million Dollar Portfolio we already do own many stocks like it, including a couple of those named above.
Why? In POOR's case, because things are going to change big time in 2020, when POOR's 10-year drought of GAAP profits will suddenly come to an end. After "depreciating" the final $10 million of its start-up factory costs, POOR will emerge into profitability. Its "losses" a thing of the past, all of a sudden, POOR will acquire a positive P/E ratio -- and a lot of professional investors will begin wondering whether that P/E ratio is low enough to make the stock a "buy."
Foolish investors, of course, knew that POOR was a rich investment all along. Because like the companies named above, and like Buffett's Berkshire, POOR suffered from the happy dilemma of making too much money.
The moral of the story
Wall Street's piled high with accounting degrees and CFAs. If it makes them happy to obsess over GAAP profits -- let 'em. Meanwhile, we'll just keep counting the cash.
Would you like to find a company like POOR in real life? Maybe one running the same kind of cash-rich business as the companies named above -- but at a more reasonable price? Sure you would. And all you need to do to get started is click right here, and we'll tell you how to get started building your very own Million Dollar Portfolio.
True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community.
Fool contributor Rich Smith does not own shares of any company named above. Berkshire Hathaway and Coca-Cola are Motley Fool Inside Value recommendations. Berkshire Hathaway and Ford Motor are Stock Advisor choices. Coca-Cola is an Income Investor recommendation. The Fool owns shares of Berkshire Hathaway, Coca-Cola, and Teva Pharmaceutical Industries. The Fool has a disclosure policy.